Friday, January 24, 2014

While the paper is rather old, an analysis of the American housing market
prepared by Randal O'Toole at the Cato Institute provides us with a very
succinct analysis of where the American housing market went so wrong. The
paper "How Urban Planners Caused the Housing Bubble" is an issue that
I have posted on before but rarely have I seen such a complete analysis.

First, let's look at a bit of basic
macroeconomics, the stuff that used to make our eyes glaze over during those
first year economics courses. Prices of everything are dictated by supply
and demand; equilibrium price of a home, in the case of this posting, is
dictated by the intersection of the supply and demand curves as shown on this
diagram:

The intersection of the two curves marks the point where the
market is in perfect equilibrium; at this point, prices will remain stable.

Now, let's look at the concept of
elasticity. Elasticity or the sensitivity of prices to changes in supply
or demand is defined by the steepness of the supply and demand curves.
Where the supply curve is flat or elastic, large changes or shifts in
demand as shown by the shift from demand curve 1 to demand curve 2 will result in only slight or no changes in price
as shown on this graph:

Again, this is called an elastic
supply situation. When supply is perfectly elastic, changes in demand
will have absolutely no impact on prices.

On the other hand, where the supply
curve is steep, large changes or shifts in demand as shown on demand curve 2
will result in large changes in price (price moves from P1 to P2) as shown on this graph:

Note that price has jumped from P1
to P2. This is called an inelastic supply situation. When both
supply and demand are inelastic, small changes in either supply or demand can
result in large changes in price. This is exactly the situation that created
the housing price bubble in the United States during the first half of the new
millennium. In the United States (and Canada for that matter), it is a
given that most Americans and Canadians are unwilling to live without a home,
particularly desiring single-family homes. This means that the demand for housing
is inelastic which means that small changes in the supply of homes, particularly
new ones, can lead to large changes in price.

Before 1970, median house prices in
much of the United States were in the range of 1.5 to 2.5 times median family
incomes. When there is no restriction on the supply of housing, house
prices generally grew only when median family incomes grew and generally followed the trend of inflation. However, as
we noted above, when the supply of homes is restricted, markets become abnormal
and prices grow at rates that are in excess of normal. This was the
problem for some areas of the United States over the past decade or more; many
jurisdictions implemented housing development growth management laws (also known
as urban containment) that placed restrictions on the use of vacant land for
housing, creating a situation where the supply of housing became inelastic
(i.e. where small changes in demand resulted in large changes in prices because of housing supply constraints).

Let's look at an example. In
Houston, developers faced little government regulation, resulting in a supply
curve for housing that is almost perfectly elastic (i.e. changes in demand will
have little impact on pricing because there is ample supply). In the Houston area, developers often
purchase parcels that are 5000 to 10000 acres in size, subdivide them into
lots, build the necessary infrastructure including roads, sewers etcetera and
then sell the lots to builders. Homebuyers then pay the costs of the
infrastructure over 30 years. This has resulted in thousands of home
sites being available to home builders at any given time. Between 2000
and 2008, the Houston metropolitan area grew by nearly 125,000 people per year
or ten times faster than the population growth rate of 85 percent of American
metropolitan areas. Yet, despite the very significant demand, this graph
shows what happened to hosing prices in Houston (and other similar
municipalities) between 1995 and 2009:

Note the complete lack of a bubble
despite very significant housing demand. Between 2000 and 2008, Atlanta,
Dallas - Fort Worth and Houston metropolitan areas each grew by more than
120,000 people per year and all areas on the graph grew by more than 2 percent
annually.

Now, let's look at the other
extreme. Eight counties in the San Francisco Bay area have drawn
urban-growth boundaries that exclude 63 percent of the region from development.
This has meant that it is extremely difficult for developers to assemble
more than a few lots at a time for new housing projects. Each house that is built
means that the supply curve is steepened further (i.e becoming more inelastic),
putting ever-increasing upward pressure on prices as building lots are
consumed. If developers in the San Francisco Bay area want to avoid the
problems associated with the restrictive land development legislation in the
immediate Bay Area, they have to look to land in the Central Valley, 60 to 80
miles away. This graph shows what happened to housing prices in central
California and the Bay Area between 1995 and 2009:

Pop goes the bubble! Looking at population growth rates,
the San Francisco Bay area, including San Francisco, Oakland and San Jose, grew
by less than 20,000 people per year or 0.4 percent annually. Areas in
central California grew by less than 30,000 people per year. This means that we cannot attribute the bubble in prices to over-demand for housing since demand was not particularly strong.

To give you some idea of the
differences between the two scenarios, here are some statistics comparing San
Jose, a highly regulated market and Dallas, a basically unregulated market:

Price of land:

Dallas - 7000 square foot lot -
$29,000

San Jose - 2400 square foot lot -
$232,000

Permitting Costs:

Dallas - less than $10,000

San Jose - $100,000

Impact Fees to pay for roads,
schools and other services:

Dallas - $5,000

San Jose - $29,000

Now, let's look at the state level
statistics. Here is a graph showing housing prices in the states with
housing bubbles:

Here is a graph showing housing
prices in the states without housing bubbles:

All of the states that have
experienced housing bubbles, excluding Nevada, have growth-management (urban containment) laws in
place.

Many economists are now questioning
whether or not another housing bubble is starting to build.
Unfortunately, it is almost impossible to recognize a bubble until it
bursts, however, economists note that each successive housing bubble pushes the
house price to median income ratio further from the natural affordability ratio
of 3.0 or less. A recent study by Demographia shows that many of America's largest housing markets are still highly unaffordable by a median family:

This suggests that the United States
housing market still has a long way to readjust before economic equilibrium is
reached and that the lesson of the negative impact of urban containment on
housing prices has not been learned.

Subscribe To

About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.